The Benefits and
Methods of Harvesting Your Losses, and Not Just at Year-end
Robert Gordon, Twenty-First
Securities Corporation and Jan Rosen,
editor of The New York Times Tax Section.
published in The Journal of Wealth Management, Fall 2001.
The material in this article is adapted from a chapter in Wall
Street Secrets for Tax-Efficient Investing by Robert N.
Gordon and Jan Rosen, published by Bloomberg Press, November
Taxable investors who focus on
realizing capital losses only at year-end are leaving a lot of
performance on the table. Knowing how - and when- to harvest
losses can significantly mitigate the damage losses can do to your
the importance of loss harvesting as part of disciplined year-round
portfolio management, the practice has received only a relatively
small amount of attention from academics and practitioners.1
In a recent study,2 Robert D. Arnott, managing partner
of First Quadrant, L.P, Andrew L. Berkin, Ph.D., associate
director, and Jia Ye, Ph.D., conducted 400 Monte Carlo
simulations, each with a universe of 500 assets.3 They
thus generated a 25-year history of monthly returns subject to a
35% average tax rate for each asset. They found that the excess
return generated from monthly lost harvesting was 80 (after-tax)
basis points annually. They report: "Over a 25-year span,
assuming modest 8 percent returns on stocks, we earn an average of
almost 2,000 basis points of cumulative alpha just from harvesting
the losses." They add: "and that's net of all of the
taxes that you would face at the end of the period for liquidating
the portfolio. It's a very important source of after-tax alpha,
and it's both reliable and predictable."
results are quite consistent with Stein , which reports a
tax-management alpha ranging from 0.7% to 1.5% per year, on
average, over a 10-year period for a large capitalization U.S.
equity portfolio, assuming average market returns respectively
ranging from 15% to 4%.4
we are aware of a long/short hedge fund that proactively harvests
losses and has generated almost 50 cents in losses for every
dollar invested. But that is far from typical. Psychologically, it
is difficult for many people to admit error, and consequently,
studies have shown, investors tend to sell winners and hold losers
in the hope that the losers will come back at least to where they
bought them.5 And yet, for both maximum investment
performance and tax efficiency, it is better to sell a portfolio's
losers and hold the winners.
this article, we address the rules, pitfalls, and methods
investors may utilize in realizing losses in their portfolios.
Winners And Losers
simplest way to harvest losses when a portfolio has both
unrealized winners and losers is to harvest them together. Because
capital losses can offset capital gains dollar for dollar, an
investor who believes a winner has had its run can sell it and
avoid a tax on the capital gain by selling a holding with an
equivalent loss. Under the tax code, short-term losses are taken
first against short-term gains, and then long-term losses are
taken against long-term gains. Finally, the net short-term gain or
loss is taken against the net long-term gain or loss. If that
results in a net capital loss, up to $3,000 a year can be taken
against ordinary income, like salaries, dividends, or interest.
Losses in excess of $3,000 can generally be carried forward to
future years to be taken first against capital gains and then
against ordinary income (with the same $3,000 limit).
a tax perspective, capital losses are most useful when applied
against ordinary income or short-term gains, because long-term
(that is, more than one year) capital gains are taxed at a maximum
rate of 20%. That rate is just over half the top rate on ordinary
income of 39.6%. This is an important factor to consider when
deciding whether to recognize a portfolio loss.
portfolios with paper losses do not always have paper gains that
neatly offset them, and often investors still have faith in a
holding that is under water. So the problem becomes how to have
it both ways: recognize the loss for tax purposes but keep the
holding. That is possible, but investors must be mindful of the
"wash sale" rules,6
which mandate that new shares cannot be repurchased for at
least 31 days after any loss is realized. Various updates to the
rules have been made to include wash purchases from unprofitable
short sales and the reestablishment of successor positions using
there are ways to operate within the wash sale rules and keep the
same economic exposure, but first let's look at the more
traditional methods employed by investors and often recommended by
which do necessitate a change in the payoff pattern.
The first choice is to sell the stock and not reinvest for 31
days. Doing this, the investor would sacrifice any appreciation on
the security during that time, and conversely would be protected
from any further slide in its price.
A second choice is to sell the loss position and purchase another
security that you believe will "act" like the original
holding. Here the investor must weigh the viability of the
possible substitutes. High-grade bonds seem the most homogeneous
as an asset class and the easiest to swap between, while small-cap
equities seem the least interchangeable. In the real world, even
blue-chip stocks in the same industry are not surrogates for each
other. Within an industry, there are often both winners and
a bond of a different issuer, or purchasing a different bond of
the same issuer but with a different interest rate and maturity,
should allow the investor to deduct the loss and avoid running
afoul of the wash sale rule. He or she might consider selling the
bond to establish the loss for tax purposes and then buying it
back after 31 days. The waiting period is crucial. If an investor
buys the same (or a substantially identical) security within 30
days before or after the date of the sale, the transaction is
classified as a "wash sale," and the loss on the sale
cannot be deducted .8
Up On Shares
alternative long favored by tax advisers and portfolio managers
has been to "double up." This involves buying an equal
parcel of the security that has the unrealized loss, and holding
these shares along with the first lot a minimum of a requisite 31
days. At the end of the 31-day waiting period, the same number of
shares is sold and the tax lot chosen is the first parcel of
shares. This identification must be made with the broker. It
should appear on the sales confirmation, and it could read
"against shares purchased (original shares' purchase
date)." Of course, while technically crafted to travel the
wash sale rule safely, doubling up means the investor is being
asked to assume twice the risk/reward.9
a far more effective approach that does not entail any additional
risk is the doubling-up forward conversion that enables the
investor to hedge all the
risk of the second lot of shares. It requires additional
capital, but the investor can earn a reasonable rate of return on
that capital. Under this strategy, the investor purchases additional
shares of the underwater holding, doubling the original holding,
buys a put on the new shares, and sells a call with the same
strike price as the put on the new shares. This series of
transactions - and the order of execution is important - enables
the investor to recognize the loss while avoiding both a wash sale
and any additional market risk:
Doubling Up Without Doubling the Risk
1,000 shares purchased at $50
2nd 1,000 shares purchased at $10
1,000 shares 9/12/90-3/15/01
2,000 shares 3/15/01-4/20/01
Sell 1,000 shares@$10
Deliver shares purchased at $50, realizing $40 loss
1,000 shares thereafter
transaction that has no risk should return the risk-free rate, not
zero. This is the equivalent of earning interest on capital while
invested for the legislated 31 days. We have recommended that
clients execute the hedge with options on the underlying shares.
Specifically we suggest
selling calls and buying puts that have the same strike
price and expiration (a forward conversion). Using the
2nd 1,000 shares purchased at $10
Sell a call option with a $10 strike price
Buy a put option with a $10 strike price
Both have a 4/20/01 expiration
risk: 1,000 shares 3/15/01-4/20/01,
instead of 2,000 shares
complete the example, the value of the call sold should (at
today's rates) be 4 cents more than the cost of the put, netting a
6% annualized profit at expiration. If the shares are above $10,
you can be sure they will be called away. If the shares are below
$10, then the investor exercises his or her put to sell at $10.
Either way the exit price has been contracted for at inception. Of
course, the investor delivers the shares purchased on 9/12/90 to
close the transaction.
strategy can (and should) be used all year but cannot be put into
place after November 30 for any given year because the necessary
31 days must occur before year-end.
an investor with a sizable position, it has generally been thought
possible to sell shares and immediately reestablish the position
through the entering of a swap without running afoul of the wash
sale rules. This belief was grounded on the basis that the rules
applied only to stock and securities, and that swaps were not
"securities." In addition, the wash sale rules apply if
the investor sells stock at a loss and within 30 days enters into
a contract to acquire such stock. However, on December 29, 2000,
the wash sale rules were amended to include contracts that settled
in cash or property other than the stock sold.
amendment might cause swaps to be captured by the wash sale rules.
When attention is focused on an effective method of avoiding
taxes, Washington frequently moves to halt it. "Selling short
against the box" had traditionally been the favored way to
lock in profits without selling the shares until Estee Lauder and
her son Ronald Lauder used it successfully when the family sold
its cosmetics empire to the public in late 1995. Following public
outcry at the transaction, the Clinton administration proposed
regulations that were subsequently adopted to curb use of the
disadvantage to swaps is that they are available only to those
with larger positions (since most swap dealers have $3 million to
$5 million minimums). We have found that the hedged double-up
transaction is more widely embraced by the tax community, and thus
we have seen most activity there. Significantly, however, a swap
can be accomplished until the last day of the year. It should be
noted that equity swaps are generally available for five years at
transaction that alters the economic position of the investor but
is still used is to sell the stock and immediately write a put on
it. As the writer of a put option, the investor is obligated to
purchase the stock if the holder of the put exercises it. As long
as the stock remains below the strike price of the put on the
expiration date, the put will be exercised.
Internal Revenue Service has ruled that the writing of the put can
violate the wash sale rules, if the strike price of the put is so
far in excess of the stock's price at the time that it was
written, that it is almost certain that the put will be exercised.
If the exercise price is not too high, then the wash sale rule
would be avoided. However, the investor will forfeit the
appreciation in excess of the strike price of the put. Investors
planning to use this strategy might consider using
"European"-style options to avoid the early exercise of
conclusion, unrealized losses are an asset11 that must
be utilized in the desire to achieve the highest after-tax returns
with the least amount of risk. Though there are several potential
alternative ways to execute such transactions, two issues need to
the transaction create any incremental and unintended overall
the cost of the transaction justify the anticipated tax
these two questions will usually lead investors toward strategies
such as the double-up forward conversion or the simultaneous
purchase of a reasonably similar security, and away from the
traditional approach involving doubling up.
Quadrant's 400 simulations encompassed a wide range of market
conditions, from bull markets as good as (or better than) the most
recent 25-year span and bear markets as bad as 1929 to 1953, a 25-year
span in which the price of domestic equities fell.
each simulation, the authors monitored two portfolios - a buy-and-hold
portfolio and a tax-advantaged portfolio. In the buy-and-hold
portfolio, the only transactions that occur are those forced by
corporate actions like takeovers and mergers. The tax-advantaged
portfolio was swept every month, and all assets with losses were
sold and immediately bought back.
each month," the authors wrote, "we ask the simple
question: if we were to liquidate both portfolios right
now, how does the tax advantaged portfolio compare to the
passive buy-and-hold benchmark, after all remaining taxes have
been paid?" Even after 25 years, they found, the tax savings
were around 0.5% a year, "an
alpha that most active managers can't add reliably even before
25 years, they found, the median cumulative gain from loss
harvesting was nearly 20%, or about 80 basis points a year.
"Despite the fact that the simulation will cover scenarios
with splendid returns and scenarios with awful returns," they
said, "the range is surprisingly tight: from 60-100 basis
points per annum is added through loss harvesting. Interestingly,
the best value-added typically comes from the scenarios with lackluster
returns: the opportunities to harvest losses, over a span of
many years, are best if market returns are poor."
material in this article is adapted from chapter in a forthcoming
book by the authors entitled Wall
Street Secrets for Tax Efficient Investing, to be published in
November 2001 by Bloomberg Press.
See Roberto Apelfeld, Gordon Fowler, Jr., and James P. Gordon,
Jr., "Tax-Aware Equity Investing," The Journal of Portfolio Management (Winter 1996), pp. 18-28; Jean
L.P. Brunel, "The Upside-Down World of Tax-Aware
Investing," Trusts and
Estates (February 1997), pp. 34-42; Roberto Apelfeld and Jean
L.P. Brunel, "Asset Allocation for Private Investors," The
Journal of Private Portfolio Management (Spring 1998), pp. 37-54;
David M. Stein and Premkumar Narasimhan, "Of Passive and
Active Equity Portfolios in the Presence of Taxes," The
Journal of Private Portfolio Management (Fall 1999), pp. 55-63.
Arnott, Robert D., Andrew L. Berkin, and Jia Ye. "Loss
Harvesting: What's it worth to the Taxable Investor." The
Journal of Wealth Management (Spring 2001), pp. 10-18.
The appendix presents some more information on the First Quadrant
The lower the market return, the higher the expected value added
from tax management, as the lesser the build-up of unrealized
capital gains in the portfolio.
See Hersh Shefrin, "Recent Developments in Behavioral
Journal of Private Portfolio Management (Summer 2000), pp. 25-38,
for a discussion of this phenomenon, often called "the
disposition effect" or "get-even-itis."
Internal Revenue Code, Section 1091.
See "Harvesting Your Equity Portfolio for Tax
Efficiency," a special report for individual investors from
Merrill Lynch, dated October 26, 2000.
But is not completely lost. It can indeed be incorporated in the
tax basis of the security bought with the proceeds of the sale.
It can further be argued that the doubling-up strategy assumes
that the investor always has excess cash available for such a
purchase or that he or she can sell other shares - presumably
without realizing too much of a gain. The incremental risks
associated with these assumptions are equally important.
The New York Times, December 1, 1996, "Rushing Away from
Taxes," by Diana B. Henriques and Floyd Norris.
Brunel  argued that unrealized losses have many of the
characteristics of a free option. Brunel  takes the idea
further, suggesting that the option value of volatility plays an
important role in tax-efficient portfolio construction. See Jean
L.P. Brunel, "The Role of Alternative Assets in Tax-Efficient
Portfolio Construction," The
Journal of Private Portfolio Management (Summer 1999), pp.
|This article and
other articles herein are
information purposes only. They are not intended to be
an offer to engage in any securities transactions or to
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have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
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Options involve risk and are not suitable for all
investors. Before engaging in an
options transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options".